The Great Paradox: Why Stocks Aren’t Getting Respect

Investors love to imagine their decisions are based on logic and foresight. But by using inconsistent arguments, investors have fooled themselves yet again, and created what I call the “Great Paradox.”

For example, stocks have become the Rodney Dangerfield of investments: They can’t get no respect. Despite corporate earnings increasing 125 percent since 2009, many investors remain skeptical of the outlook for stocks. Bloomberg News reported recently that valuations for U.S. equities have been stuck in a remarkably long-running slump that hasn’t responded to this surge in profits, suggesting that investors don’t trust the growth to continue.

That lack of trust is evident in the low Price-to-Earnings (P/E) ratio of the S&P 500, currently less than 13 times the 2012 earnings forecast. Compare that to the average historical P/E ratio of 16.4 times. If investors valued companies in the S&P 500 according to the historical average P/E, the S&P 500 would be 30 percent higher. But no such luck.

Corporations proved their flexibility and adaptability during the Great Recession. Corporate profits have been very strong, rebounding much faster than GDP. Corporations now run leaner than they did a few years ago and will benefit greatly from any economic tailwind. Yet many remain skeptical that this profit resurgence will be sustained.

On the other hand, bonds have performed extraordinarily well in recent years - so well, in fact, that many (myself included) see limited remaining upside. There’s not much of anywhere for long-term bond prices to go other than down, since those values run directly inverse to interest rates, which are currently nearly as low as they can be. Meanwhile, despite a worsening fiscal government outlook, U.S. Treasury bonds have done so well over the last 30 years that they have outperformed stocks. The last time that happened was prior to the Civil War.

Still, investors have poured billions into bond mutual funds over the last five years, and have removed billions from stock mutual funds. According to data aggregated by TrimTabs, investors have removed money from U.S. stock mutual funds in each of the last five years, including approximately $100 billion last year alone. Meanwhile, investors have added money to bond mutual funds in each of the last six years, including more than $110 billion into bond mutual funds last year. Investors seem to think that bonds will continue to appreciate indefinitely; at the same time, they distrust that current corporate earnings will continue. They have fallen into the Great Paradox.

Call me crazy, but I believe fundamentals matter. As Warren Buffett observed, “In the short term, the market is a popularity contest. In the long term, the market is a weighing machine.”

There’s no reason to think stocks won’t perform well in a slow-growth economic environment and even better in a good environment. And unlike for bonds, being a strong performer isn’t an anomaly for stocks. For those with a sufficiently long-term perspective, clinging to bonds isn’t a position that makes sense. As Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton School in Philadelphia, told Bloomberg News, “The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform. If you missed the rally in bonds, well, then that’s it.”

Why are so many people tempted to keep favoring bonds and avoiding stocks, ignoring solid reasons to do the reverse? One reason could be herd mentality. As my colleague Benjamin Sullivan observed, many investors follow the crowd, buying overvalued stocks when the financial media and Main Street are optimistic about the market, and shunning stocks when prices ebb, despite the fact that it makes more sense to buy low and sell high.

Think about it. Should you buy stocks when everyone thinks the world is ending - say in March 2009, when the S&P 500 closed as low as 677 - or when everything is Pollyannaish - say in October 2007, when the S&P 500 closed as high as 1565?

Though the timing is difficult to pinpoint, one should to try to buy near the height of pessimism and sell or reduce close to the height of optimism. As legendary investor Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

Investors may also be tempted to let past performance overly determine their expectations for future behavior. However, while it’s smart to glance in the rearview mirror from time to time, looking only backwards and ignoring the path ahead will inevitably lead to messy smash-ups.

No one can forecast exactly what the market will do in the short term. But there’s no reason for the excessive pessimism that investors seem to apply only to stocks. This summer, Burton G. Malkiel, a professor of economics at Princeton, wrote in The Wall Street Journal: “We have abundant evidence that the average investor tends to put money into the market at or near the top and tends to sell out during periods of extreme decline or volatility. Over long periods of time, the U.S. equity market has provided generous average annual returns. But the average investor has earned substantially less than the market return, in part from bad timing decisions.”

Uncertainty is frightening, and it isn’t surprising that investors are tempted to cut and run at the first sign of trouble. Investors have clearly lost confidence in stocks in recent years. But post-recession, it seems many investors have gone a step farther than caution. I suppose two bear markets during the same decade are enough to make investors jumpy. Meanwhile, investors pile into a bond market with limited upside and considerable downside.

Warren Buffet made the following analogy: “I’m going to buy hamburgers for the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up, we weep. For most people, it’s the same way with everything in life they will be buying - except stocks. When stocks go down, you can get more for your money, but people don’t like them any more. That sort of behavior is especially puzzling.” It’s not only puzzling; it’s costly.

Hockey legend Wayne Gretzsky put it best when he said, “I skate to where the puck is going to be, not where it has been.” The puck has spent the last five-, 10-, and 30-year periods making money for bond investors. I suspect the next five, 10, and 30 years are going to be in stocks’ end of the rink.

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